Nassim Nicholas Taleb, of Black Swan fame, joins the chorus in attacking asymmetrical bonuses, the “head’s I win” if things go well, “tails you lose” syndrome.
An oversight in this piece is that this approach nevertheless worked reasonably well in the old Wall Street. Why? The big reason was that you had owner/managers whose capital was at risk making the bonus decisions. And in the old days, partners had smaller spans of control. Any unit or desk that was a reasonable size profit center had a partner in charge, which meant they were working side by side with the troops, familiar with the risk of deals and positions and able to observe individual actions at close range.
The old Wall Street also featured far less cash comp. The line at Goldman was that partners lived poor and died rich. When they became partner, they took a considerable cut in current income from what they would have been making as vice presidents (their partnership earnings were reduced by the interest on the loans to acquire the stake). Thus new partners had to keep working hard to increase their ownership stake in the firm to realize a better lifestyle. And the VPs and juniors were no where near as well paid (relative to average salaries) as in recent years. They certainly lived well by any standards, don’t get me wrong, but their is a big difference between being well paid and lavishly paid.
Taleb suggests that rewards need to be more symmetrical, with performers taking hits or having clawback provisions, but does not say how they might be put into effect. He also reminds us that money is not the only reward system; in other professional cultures in the US, pay differences are minor; status and reputation count for more.
From the Financial Times;
One of the arguments one hears in the compensation debate is that the bonus system used by Wall Street ….is there to “reward talent”. While I find this notion of “talent” debatable, I fully agree that incentives are the heart of capitalism and free markets – but certainly not that incentive scheme.
In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich….
Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses. As you do not disgorge previous compensation, the incentive is to engage in trades that explode rarely, after a period of steady gains.
Here you can see that this mismatch between the bonus payment frequency (typically, one year) and the time to blow up (about five to 20 years) is the cause of the accumulation of positions that hide risk by betting massively against small odds….
If capitalism is about incentives, it should be about true incentives, those resistant to blow-ups. And there should be disincentives to remove the asymmetry of the free option. Entrepreneurs are rewarded for their gains; they are also penalised for their losses. Now, by comparison, consider that Robert Rubin, the former US Treasury secretary, earned close to $115m (€90m, £80m) from Citigroup for taking risks that we are paying for. So far no attempt has been made to claw it back from him – only UBS, the Swiss bank, has managed to reclaim some past bonuses from its former executives….
[W[hen it comes to banks and other “too big to fail” entities, the problem is severe: we taxpayers in our respective countries are funding these global monsters and are coughing up money for mistakes made by bankers who retain their bonuses and are hijacking us because, as we are discovering (a little late), banking is a utility and we need them to clean up their mess….
The Obama administration has been trying to set compensation limits for banks under the troubled asset relief programme. But this is insufficient. We need to remove the free option. Beware the following situations.
First, those who are taking risks even outside Tarp or society’s protection can still be gaming the system – since their risk-taking can result in a collapse, with the taxpayer having to step in. For instance, Goldman Sachs, the US bank, might want to avoid the limits on executive compensation for its managers. That should be fine so long as society does not have to bail out Goldman Sachs (or, worse, its creditors) in the future.
Second, Vikram Pandit, Citigroup’s chief executive, while claiming to want to earn one single dollar a year in compensation unless the bank returns to profitability, is still getting a free option given to him by society. He does not partake of further losses; we do.
Third, leveraged buy-out companies used the free option by borrowing heavily from the banks and taking monstrous risks: they get the upside, banks (hence we taxpayers) get the downside. These partnerships made fortunes in the past on deals that society will have to bail out. They too should have their past profits clawed back.
Indeed, the incentive system put in place by financial companies has produced the worst possible economic system mankind can imagine: capitalism for the profits and socialism for the losses.
Finally, I was involved in trading for 21 years and I can testify that traders consciously play the free option game. On the other hand, I worked (in my other job as risk adviser) with various military organisations and people watching over our safety. We trust military and homeland security people with our lives, yet they do not get a bonus. They get promotions, the honour of a job well done and the disincentive of shame if they fail. Roman soldiers signed a sacramentum accepting punishment in the event of failure. This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.
No incentive without disincentive. And never trust with your money anyone making a potential bonus.
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Every business you manage on an existing customer base can be played anticipating profits: so, why should I not do it if the pay-off is high enough? Once I cashed in the million-buck prize I start again targeting carrier and millions: if anything goes wrong anyway I got my parachute, right?
I don’t think the problem is the size: the problem is the timing. You must be sure that an extra-ordinary remuneration follows extra-ordinary results which are not simply anticipating the future (i.e. you are killing your customer base betting the bubble never bursts so that nominal values hide the erosion of the underlying asset).
Not only did you have partnerships on wall street where everyone’s capital was at risk, but a direct result of that was the strong emphasis on broker-dealing as agent as much as possible and as principal as little as possible.
The investment banks need to go back to the partnership model. They way to go forward is to assign a fixed amount of capital to each partner. They can lose it all and either leave or ask the other partners for a new share.
If they get a deal that will risk more than they are responsible for, then they must get one or more partners to syndicate with them. If they cannot sell the deal to the other partners so be it.
At the end of the year, they can take a fraction out of their capital as reward. If they have lost, they need to return a similar percentage. The bonus is not to exceed 1/2 o their annual salary, that way, it can be returned.
When they retire, they get to take out a lion’s share. Leave the firm before then, get nada.
Good luck in getting such a plan through.
If fewer people from the science/engineering/etc fields get sucked into Wall St jobs as a result of lower bonuses and end up pursuing productive work instead, I consider that a good thing.
I don’t get why no one has picked up on Jeff Bezos’s suggestion that the Gumment should simply TAX salaries. Why not a RETROACTIVE to 1/1/08 – remember the retro tax on shelters???? – steeply progressive tax on wages and bonii starting at $500,000 and starting 1/1/08?
This would catch avaricious, egregious cooking or skewing the books in TY ’08 like Blankfein. Essentially his $40M+ ’08 bonus has or will be paid by Joe Average taxpayer. But then again WE are all paying Franklin Raines’s $100K/MONTH retirement – in Bermuda – for his stellar management skills, again largely confined to skewing the books.
Yves,
The next thing you are going to suggest is that we get the greedy insurance comapnies out from the middle of health care. Have health care focus on providing health rather than making some people rich.
There are some things that it is best to keep the greed of capitalism away from. Others, not so much.
Thanks Yves for your clarity in solution.
This is nuts…every entrepreneur gets free option too…he borrows from banks and tries to grow the business and if it does not work, then he walks…what Taleb is attcking is the Limited Liability concept…good luck repealing that…
Is not the present value of a future stream of income from a healthy bank more than a much shorter stream with larger bonuses from a more risky firm? In other words, if I were CEO of Bank A and had the option to engage in risky behavior for the chance to double my normal pay, would it still not be advantageous to opt for a less risky path given the potential short-lived nature of my future income stream (i.e. 10 yrs at par vs. 3 years at twice par)? I do not agree that managers were so short sited, especially given the enormous intangible costs associated with public shaming. I think management pay is far too simplistic a cause for excess risk taking. What is more likely is that managers thought their actions were not as risky as we now know them to be. What number of standard deviations would describe a nationwide fall in housing prices using 50 years of data?
“capitalism for the profits and socialism for the losses”; but it isn’t capitalism, is it, if the shareholders (the capitalists) get rooked by the executives? It’s a form of Workers’ Control, with the power limited to the upper strata of workers. Call it UberWorkers Control.
Yves:
Considering the sums involved, a Citiczar is much more important then a Car Czar ever was.
think that such a big job needs a big man.
“Good evening Mr. Volker. In the canyons of Wall street a rampaging giant is trying to break into the Federal reserve vault. Your job if you accept it is to hog-tie him.
This tape will self destruct…”
@Anonymous 12:44 pm : sure, but that entrepreneur hasn’t received billions in government bailouts.
Further on your theme though, in the case of AIG we actually own the company, 79.9%. An overwhelming controlling interest. So we should do what is right for us. And that is indeed to walk, no more money down that particular black hole. Liquidate AIG, pay off as many senior creditors or trading counterparties as possible and wind it up. Don’t use it any more as a conduit for tax money to GS.
This is nuts…every entrepreneur gets free option too…he borrows from banks and tries to grow the business and if it does not work, then he walks..
Not even close to analogous. When the entrepreneur’s company turns insolvent, does he get a $100M payout?
Rubin did.
JP: my comment is in reply to free option
“This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks”
If bank leverage ratios are kept sane then most of the problem goes away. Or at least it moves over to the shadow banking system.
Seems that Republican leadership will not be in favor of sanity with respect to the banking system either. Eric Cantor (who was pushing the “insurance” version of TARP back in the day) is big on “getting credit flowing again.”
We need another grass-roots effort! Get on the phone to your Representative and Senators, same as we did with TARP.
Anonymous wrote: “In other words, if I were CEO of Bank A and had the option to engage in risky behavior for the chance to double my normal pay, would it still not be advantageous to opt for a less risky path given the potential short-lived nature of my future income stream (i.e. 10 yrs at par vs. 3 years at twice par)?”
There are too many undefined parameters. Some I can see that might be of relevance in the current situation:
1) What is your personal financial situation? Maybe you only need the three years at twice par to get you to the point where you don’t need to work. So grab your cut, let it crash, and walk out of the wreckage laughing.
2) How bright are you? Maybe you don’t even realize (despite your salary and bonuses) that your actions will destroy the company in three years. Hoocoodanode?
3) Where do you fall in the power structure? Even if you see the problems, maybe your boss doesn’t, and doesn’t want to hear about them. Or maybe your investment clients will all walk if you change to the safer behavior, because they aren’t getting the better returns – meaning, somewhat paradoxically, that the safer alternative will also destroy the company, at least, as long as there are others out there taking the stupid (but profitable in the short-term) path.
4) Do you think you can game the system so the company will survive the debacle? Maybe your company is “too big to fail” and the government will step in to socialize your losses. They may even keep you on at your current benefits package, since after all, expertise such as yours is rare.
5) Do you think you can game the system so that you personally will survive the debacle? Maybe you can get a job at another company, thanks to your good buddy Bob who’s on the board (and whose benefit package you judged as reflecting market value, when you were his “outside” evaluator).
Reward winners not talent.
.every entrepreneur gets free option too…he borrows from banks and tries to grow the business and if it does not work, then he walks…
Lots of entrepreneurs, especially small buisness owners, have to provide their lenders with personal guarantees, limited liability or not. If the businees fails, they are still on the hook.
My anecdote:
I was hanging with a CPA, who was very conservative in their decisions and practice in order not to risk losing their certification. They advised me that, in a previous company, they and others in that company’s Accounting Department would play a hypothetical game: How much would you have to make via a fraud scheme in order to try to rip off your company?
Being CPA’s and other dry accounting types, they would hedge their answers by saying 1) it was tax-free; 2) they would remove themselves to a country they could live in that would not extradite them back to the US, and 3) you couldn’t get caught before you absconded. The answers were in the range of $2-$7 million.
Very ethical people, concerned about their professional certification and lives, would take that much to basically repudiate and run from their current lives.
Some of those on Wall Street were making this much at least annually, let alone bonuses. And their positions were not ones requiring the same level of moderation and ethical commitment as these auditors.
Somehow, I do not see that their price would have been higher.
Taleb is right, that is exactly why they all went mad, there was little downside and monstrous upside. If you got @ 2/5 yrs worth of bonuses, you were set for life. Also they instinctively knew that if public deposits were at risk, the government/taxpayer would almost certainly bail them out, which is what has happened.
Bring in a new Glass Steagal and require the deposit takeing banks to be conservative.Anyway the mkt will soon sort out any deposit taker, takeing risks, then you have the deposit takeing banks unable to make huge profits. More importantly they won’t get into a position where they can blackmail the government into bailing them out, to protect depositers.
Let investment banks do what they like, but under the condition that there is never going to be a bail out again and that all management are paid bonuses in shares that only redeem at the official retirement age. Even let them borrow against the shares, but a fully commercial rates.
Then go after all of them for fraud, seize all their assets, jail them, throw away the key and let that stand as a terrifying warning to anyone else who wants to try it on.
Night clubs should be good businesses. Steady cash income, good margins and you pay the brewery at the end of the month. The problem is that the staff steal the money (as it’s normally dark and no-one can see what they’re doing).
The same is true with investment banks. The staff steal the money (athough they call it bonuses) and the owners get very little.
I’d like to point out that Taleb got his initial f*ck-you money from bonuses he got as a trader due to ’87 crash. So he knows what he’s talking about ;)
It’s insane, isn’t it, that we have not re-enacted Glass Steagall. I mean, we don’t even have to come up with the system, they already did that for us. All we have to do is resurrect the law.
And they have not even done that.
Are we just total chumps? We haven’t had any “Pecora” hearings either.
Nobody cares, Yves. And nobody will listen to Taleb until it affects them personally. Some lower to mid management career type loses their house, their job, their wife. So he goes over the deep end and shoots and kills Mr. Big and a bunch of his close friends in the corporate dining room. Then they care. But until then, there isn’t a single person in finance who cares what Taleb thinks unless it will make them a buck.
YS:
I read the Taleb article and have been saying similar things for years. Way to go Taleb.
I am in a state of disbelief. No matter how I try to imagine how this was printed on pink paper under the name Financial Times, surely it didn’t happen. This ranks right up there with a devout Catholic denying the existence of the Blessed Virgin.
link to Make Bankers Accountable – A “J’accuse” by Roubini and Taleb
I do not necessarily disagree with Taleb, but he is so utterly arrogant I had to stop reading his book. Boy he is soooooooooo smart. Let’s stop quoting this blowhard and tell him to stick it up his nose with a rubber hose. The sooner this guy’s 15 minutes are up, the sooner my BP will drop 40 points.
In reply to: “This is nuts […] what Taleb is attcking is the Limited Liability concept…good luck repealing that…”. That’s not at all what happens with entrepreneurs. They pay a premium on the loan in proportion to the risks they take on. They only take anything home when their profits are over and above the cost of that risk. If the business doesn’t work and the bank is unhappy, they made a mistake in pricing the risk.
The bankers are specifically rewarded with higher profits for taking on higher risks even when it is pretty much inevitable that these risks will blow up in the future. Its as if interest rates declined as risk went up and the amount borrowed wasn’t constrained by anything other than the amount of profit wanted. Bringing bankers’ risk/reward profiles in-line with entrepreneurs’ would be a huge step forward.
I concur with anonymous’s remark regarding Taleb attacking the concept of limited liability. Actually, once one understand that investment banker considers themselves as independant entrepreneur in an investment banking environment, rather than an employee of an investment bank,lots of behaviors are more easily understood.
What bothers me most with Taleb is his hypocrisy. Not only did he made his f*** you money out of the “cheap option” system, but he actually never stopped using it after 87, quite the contrary ! When one can hears him telling anecdotes on how stupid were his managers during his stint at Credit Suisse, one sees he shares the same contempt for the organisations that made him rich. He is really in the same league than Andrew Lahde. Still today, he keeps on managing/advising his empirica fund, that is mostly dedicated to find cheap options to buy (financial or “real”as they say in the industrial world).
That is a problem : you cannot at the same time say that selling options are bad, and spend most of our financial career buying them. For every buyer, there is a seller (I.e. a “moron” in Taleb Terminology…)!
Taleb tries to deflect this criticism by either stonewalling (“I don’t discuss my financial activities”) or saying that he is a philosopher/essayist now and that he left finance (“Finance is for philistines!”).The problem there is that most his publishing notoriety comes from explaining how he performed what he calls now his crime (before “the Black Swan” and “Fooled by Randomness” there was “Dynamic Hedging”…). Michael Lewis’s “Liar Poker” and Taleb’s Books are in the same league than OJ Simpson’s “If I did it”. Profits from describing your crime are no more morally legitimate that the crime itself.
Hence my issues with his “holier than thou” attitude.
OK so Taleb, along with the others with the same opportunity, played the system.
Taleb spilled the beans to outsiders. Nobody has claimed that he’s being dishonest; he is revealing some amount of real dope.
Now I can see Taleb’s former employer or employers being unhappy about it, maybe. But the outsiders he educates to can ignore him, or listen to him, but surely have nothing to complain about!
JP: my comment is in reply to free option
“This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks”
Then your comment makes even less sense. Free option? Have you never seen a term sheet?
When have you ever seen funding of a entrepreneur’s business not done without liquidation prefs, rachet, etc?
Want to throw those into options for bank execs? Go ahead.
Someone I know just got laid off from Merrill Lynch. She got one year’s severance. Is that right?? That money is coming out of my pocket. It’s obscene.
OT a bit: Willem Buiter has sketched out an extensive plan for regulatory reform: Regulating the New Financial Sector. I think his proposals deserve lots of attention and comment.
He views the compensation issue as a matter of corporate governance. This is my view as well, and is a big reason I believe the current crisis raises fundamental questions about Western capitalism.
Like Taleb, Buiter calls for a class of “banks as utilities” which would be very heavily regulated. Taleb maybe thinks that incentives alone can be structured so as to obtain responsible behavior outside these “narrow banks”; Buiter believes regulation should be lighter but pervasive.
Buiter’s proposal for dealing with rating agencies was particularly striking for me.
Today Martin Wolf suggested what Obama should say at G20. Buiter is on a parallel track with his suggestions for regulatory reform. Considering that the crisis originated here and that the dollar is at risk as the world’s reserve currency, Team USA had better take such a plan for regulatory reform as Buiter’s with them to London.
Wall Street will clean up its compensation act only when it realizes that the firm must stand or fail entirely on its own (to his credit, Mack at MS seems to be seeing the light w.r.t. compensation).
Until then, every regulatory or similar proposal on compensation reform will be decried as governmental interference, the enemy of innovation, etc., etc.–the whining will be endless and numbing.
Quit exempting institutions from the law. Let ’em fail: Use FDIC seizure and rehabilitation of the commercial banking subsidiary when found insolvent by the bank examiners and let an insolvent bank holding company file for Chapter 11. The alternative is a reprise of Japan’s lost decade and a half, only bigger and uglier.
Announce the renunciation of ad infinitum bail-outs by removing Geithner and installing Volcker in his stead.
Low hanging fruit.
Stop bailing out the frauds on Wall Street. And stop yammering about capping executive pay. It should be a private business, they can pay what they want, and Big Gov’t shouldn’t care whether they go down in flames or not. In fact, Big Gov’t should go down in flames with the Wall Street banks.
Good luck to you all. You’re going to need it.
In the end, and I don’t know what the end will look like, these chaps will be lucky to walk away with their heads on their shoulders. They are so narcissistic and arrogant that they haven’t even considered this as a possibility. In a certain abstract form they could be accused of treachery, crimes against the state, breaching and endangering national security.
However, we are in the very early stages of the vilification process, I suspect that the criminal justice pipeline will function seamlessly once it is implemented and it’s capacity is expanded.
The fact is that we as a society are far more vindictive today than in the past. Americans will demand that these treasonous members of our society be brought to justice, cowering in their shame. I would offer them no quarter.
Best regards,
Econolicious
When you see attacks on the writer rather than the point he makes, you know truth is near.
I’ve been doing some reading about the potential larger stake in Citi by the USG.
Is it possible that Citi would want a larger common share position by the US as an ‘insurance’ policy against forced liquidation?
Would the government actually wipe out the value of its own shares, regardless of what the stress test revealed?
Just curious.